You probably already know that ESOP stands for Employee Stock Ownership Plan.
But what does ESOP mean? Well, an ESOP is a qualified retirement plan that offers distinctive cash and tax advantages to business owners and companies. ESOPs are designed to share those advantages with employees and the communities where they live and work, too.
The many advantages of an ESOP require an in-depth understanding of, and scrupulous compliance with, regulatory requirements under both the Internal Revenue Service (IRS) and the Department of Labor (DoL).
That means, when you transition your company to an ESOP, you’ll need to commit to understanding many new terms, concepts, and requirements.In this article, we cover some of the most important ESOP terminology, concepts, and regulations.
Key ESOP Definitions
An ESOP Administration Timeline lists the various ESOP deliverables along with the responsible party and due date. The responsible party could be the Plan Administrator, Plan Trustee, ESOP third-party administration (TPA) firm, accountant, auditor, valuation firm, company or qualified-plan attorney, lending institution, or ESOP consultant. The level of detail needed for an ESOP Administration Timeline varies from plan to plan and year to year.
The most common key deliverables include reporting final account balances, delivering participant statements and the Summary Annual Report, conducting employee meetings, filing IRS Form 5500, and paying distributions.
Audit Closing Agreement Program (Audit CAP)
One of three components of the Employee Plans Compliance Resolution System (EPCRS) is the Audit Closing Agreement Program (Audit CAP). Under this program, the plan sponsor agrees to correct qualification failures, pay a sanction, and sign a closing agreement with the IRS.
Basis Adjustments of S Corporation Stock
Stock of an S corporation held by an ESOP is subject to the same basis adjustments under Section 1367(a) as stock held by any other S corporation shareholder. If a distribution from an ESOP is made in the form of company stock and such distribution is a lump sum distribution, the taxation to the participant is different than a cash distribution (assuming the distribution is not rolled over into an IRA or other qualified plan).
Specifically, the cost basis of the shares would be taxable as ordinary income like a cash distribution. The excess of the current fair market value of the shares at the time of the distribution over such cost basis is known as Net Unrealized Appreciation (NUA) and is taxed at the long-term capital gains rate.
An ESOP company can make a participant’s distribution in stock, cash, or both. Many ESOP participants’ accounts hold both stock and cash when they leave the company. The cash portion is paid out in cash, and the share portion may be cashed in, so the participant receives cash for the value of the shares.
Many ESOP participants leave with an account that has both stock and cash in it.
ESOP plan documents, like other qualified retirement plan documents, define compensation in the plan document for purposes of allocating ESOP contributions, determining deduction limits, and nondiscrimination testing. Depending on your plan design, there may be differing definitions for each money source (e.g. ESOP, safe harbor match, discretionary profit sharing, salary deferrals, etc.).
IRC Section 414(s) Compensation is the definition of compensation used for nondiscrimination testing to make sure the plan does not provide contributions that discriminate in favor of Highly Compensated Employees (HCEs).
A plan is not required to use a 414(s) safe harbor definition of compensation to allocate ESOP contributions. However, if a plan is not using an IRC Section 414(s) Compensation safe harbor definition, it will be subject to additional discrimination testing.
Qualified plans need to define compensation for IRC Section 415 compliance testing. This definition is also used in identifying highly compensated employees (HCEs), key employees, calculating minimum benefits to non-key employees under top-heavy plans, and determining deduction limits for Defined Contribution plans.
Complete Discontinuance of Contributions
Plan sponsors aren’t required to make contributions every year, but contributions must be “recurring and substantial” for a plan to be considered ongoing. If the employer hasn’t made contributions in three of the past five consecutive years, the plan may have incurred a complete discontinuance of contributions. A complete discontinuance of contributions can put the plan’s qualification at risk.
Section 415 of the Internal Revenue Code provides for dollar limitations on benefits and contributions under qualified retirement plans. Section 415(d) requires that the Secretary of the Treasury annually adjust the limits to meet increases in the cost of living.
Corporate governance refers to how corporations manage the business affairs of the company to achieve their corporate and shareholder objectives.
The original cost basis of an employer security in an ESOP is the value of the stock when it was deposited into the ESOP trust. While that computation is pretty straightforward, keeping the cost basis allocation accurate on a participant level can get complicated quickly. This is especially true if there are multiple stock transactions that have occurred during the life of the ESOP and the shares have not been tracked in separate accounts by transaction.
Deemed distribution language in plan documents can state that participants who are zero percent vested at the time of termination shall be deemed to have received a complete distribution of their account balance on termination or as of the end of the plan year in which they were terminated.
In another application, if an employee fails to repay an ESOP loan within five years, the IRS views the outstanding balance of the loan at the time the plan recognizes the default as a deemed distribution, meaning the IRS considers the loan balance taxable income and, depending on the employee's age, subject to an early-withdrawal penalty.
Delinquent Filer Voluntary Compliance Program (DFVCP)
The Department of Labor’s Employee Benefits Security Administration (EBSA) provides plan administrators with the opportunity to pay reduced civil penalties for voluntarily complying with the annual reporting requirements.
When an unforeseen event happens that disables a participant from continuing employment, the termination may provide additional ESOP benefits to the former employee. Since the law doesn’t require a specific definition for disability, plan documents should be drafted with definitions.
Three common definitions include determination by the plan administrator, determination by a physician, and Social Security Administration determination of disability.
Generally, a distribution is a withdrawal of funds, as in a distribution from a qualified retirement plan.
Distribution — Form
Internal Revenue Code 409(h) governs ESOP distributions. Benefits most often must be distributable in the stock of the employer corporation; however, participants do not have the right to demand stock from an ESOP that holds stock of an S corporation or a C corporation with restrictive bylaws. Closely held companies are required to extend a put option to repurchase the shares from the distributee.
Distribution — Methods
Lump sum: The Internal Revenue Code provides that an ESOP can pay distributions in a lump sum. Paying distributions in a lump sum can accelerate the company’s ESOP repurchase obligation, protect former employees from sharing in future losses in the value of the company, and allow current employees participants to share in the potential growth of the company.
Installments: The Internal Revenue Code also provides that an ESOP can pay distributions in substantially equal payments over a period not longer than 5 years. For balances greater than a certain threshold ($1,165,000 in 2021), the company can increase the number of installments paid to participants. For each additional increment ($230,000 in 2021), an additional year (up to 5 additional years) can be added to the payout period.
Distribution — Timing
Distribution of a participant’s balance must begin not less than one year after the close of the plan year during which the participant retired, became disabled or died; or within the year after the fifth plan year following the year in which the participant terminated (or was terminated from) employment.
Diversification allows active plan participants to exchange stock for cash or other investments. ESOP participants who meet certain eligibility criteria may choose to cash in a portion of their stock account to diversify investments. Under IRC Section 401(a)(28), participants who have reached age 55 and completed at least 10 years of participation in the ESOP are qualified. Your plan may establish less stringent provisions.
Employer contributions to an ESOP are tax-deductible up to a limit of 25% of covered payroll (including employer contributions to other defined contribution plans). For a C corporation with a leveraged ESOP, the 25% limit does not include loan interest payments.
A leveraged S corporation ESOP is not entitled to exclude the loan's interest expense from the 25% limit.
Plans may use elapsed time to credit employee service as opposed to tracking exact hours worked. This method, as referenced in U.S Treasury Regulatory Code Section 1.410(a)-7, considers the “total period of time which elapses while the employee is employed.” This measure is useful for plan sponsors that have difficulty tracking actual hours worked. It requires accurate dates of hire, termination, and rehire, if applicable.
Employee Plans Compliance Resolution System (EPCRS)
If you make mistakes in your retirement plan, you may use the IRS Employee Plans Compliance Resolution System (EPCRS) to fix your mistakes and avoid the consequences of plan disqualification.
It is common that plan documents will exclude the following individuals from participating in an ESOP, even though they’ve met the participation requirements allowed under the Internal Revenue Code. Excludable employees often include leased employees, employees of affiliated employers (under common control) that have not also adopted an ESOP, independent contractors, collective bargained employees (union employees), and nonresident aliens.
A fidelity bond is a type of insurance required to protect an ESOP from losses due to fraud, dishonesty, or negligence. Persons who handle funds or other property of the ESOP are required to be bonded. A fidelity bond is not the same as fiduciary liability insurance.
Fiduciary Liability Insurance
Under the Employee Retirement Income Security Act of 1974 (ERISA), fiduciaries are personally liable for the cost of their defense judgments, and penalties. Fiduciary coverage helps mitigate risk of exposure if current or former employees sue, claiming their assets weren’t handled properly, or that they received misleading plan advice.
Since employees must be vested to participate in the ESOP, employees who terminate their employment before they can be vested forfeit their right to acquire company stock through the ESOP. The loss of position can result from voluntary termination, layoffs or dismissal due to misconduct or incompetence. The company takes back possession of the shares and either holds them or distributes them to other participants.
Hours of Service
Hours of service are generally used to perform the eligibility analysis to enter the plan, determine who has met the allocation requirements to share in the contributions for the plan year, and update an individual’s vested years of service. The Department of Labor defines an hour of service. If hours are not tracked for salaried employees and the ESOP plan document provides for an equivalency option, there are several alternatives for computing hours of service.
If a company is unable to locate a former ESOP participant with a vested account balance due to participants’ moving to a new address and failing to provide notice to the plan administrator, the Department of Labor describes a fiduciary’s duties to attempt to locate missing participants.
Net Unrealized Appreciation (NUA)
Since IRC Section 4975(e)(7) requires ESOPs be primarily invested in employer securities and participants may be entitled to stock distributions, electing NUA on a stock distribution should be considered before taking a distribution from the plan.
According to Treasury Regulations §1.402(a)-1(b)(2), NUA is “the excess of the market value of such securities at the time of distribution over the cost or other basis of such securities to the trust.” If the stock in the ESOP has a low cost basis compared to the current value of the stock, it is recommended to allow participants to have the option of electing NUA.
This is one reason it’s important to track the cost basis of the stock in the ESOP.
Partial Plan Termination
If more than 20% of an ESOP company’s plan participants were laid off in a particular year, the plan may have a partial termination. If so, the law requires all “affected employees” to be fully vested in their account balance as of the date of a full or partial plan termination. They must become 100% vested in all employer contributions (including matching contributions) regardless of the plan’s vesting schedule.
Participation — Accruing Benefits
Accruable benefits are those benefits earned over a period of time while employed at a company. ESOP participants (employees) accrue shares in the plan over time. (See Vesting)
Title I of the Employee Retirement Income Security Act (ERISA) requires retirement plans, including ESOPs, be audited each year by an independent qualified public accountant (IQPA) as part of the plan’s annual report (Form 5500).
If certain conditions are satisfied, the audit requirement does not apply to a “small plan” filer.
Preliminary Diversification Forms
Qualified participants must be given an election to diversify during the first 90 days of the plan year. An ESOP community best practice is to distribute a revocable preliminary diversification form to show a good faith effort to satisfy the 90-day election requirement.
After the final account values become available and diversification amounts are computed, Final Diversification Election Forms should be prepared and distributed to the qualified participants.
Qualified Domestic Relations Order (QDRO)
A qualified domestic relations order (QDRO) splits and changes ownership of a retirement plan, including account balances in an ESOP, to give the divorced spouse or other alternate payee their share of the participant's account.
Registration-Type Class of Securities
Registration-type is a class of securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (SEA), or that would be required to be registered if not for the exemption from registration in Section 12(g)(2)(H) of the Securities Exchange Act of 1934.
The SEA was created to govern securities transactions on the secondary market, after issue. Its intent is to provide transparency and reduce fraud. Securities affected include banks, bank holding companies, savings and loan companies or savings and loan holding companies.
Release of Shares
ESOPs are allowed to incur debt to purchase stock. When company stock is purchased by the ESOP with the proceeds of an exempt loan, the shares are put into an ESOP suspense account as collateral. Shares are released from the ESOP suspense account as loan payments are made on the debt. The share release provides a predetermined share allocation to the ESOP participants over the term of the ESOP loan.
General Rule (Principal and Interest Method)
The General rule share release formula is based on principal and interest payments made on the ESOP loan:
|principal and interest paid for the year||x||shares in suspense|
|principal and interest paid for the year + principal and interest to be paid for all future years|
Special Rule (Principal Only Method)
|principal paid for the year||x||shares in suspense|
|principal paid for the year + principal to be paid for all future years|
To meet special rule requirements:
- The loan must provide for annual payments of principal and interest at a cumulative rate that is not less rapid at any time than level annual payments of such amounts for 10 years.
- Interest included in any payment is disregarded only to the extent that it would be determined to be interest under standard loan amortization tables.
- The term of the loan cannot exceed 10 years (including any renewal, extension, or refinancing)
Required Minimum Distribution (RMD)
RMDs are required withdrawals by individuals from their qualified retirement plan accounts. RMDs are generally required starting April 1 following the later of the calendar year in which a participant either reaches age 72 (age 70½ if born before July 1, 1949), or retires (if the plan allows this).
For each year after the required beginning date, the participant must withdraw the RMD by December 31. If they do not take any distributions, or if the distributions are not large enough, they may have to pay a 50% excise tax on the amount not distributed as required.
Self-Correction Program (SCP)
An ESOP can self-correct an insignificant operational error at any time to preserve the tax-favored status of the ESOP plan. An operational error occurs when the plan doesn’t follow its written terms. Even where the operational error is significant, a company may still be able to self-correct if action is taken in a timely manner.
Fair market value for the business determines the ESOP company stock price. The company stock price is determined on an annual basis by an independent appraiser, as required under IRC Section 401(a)(28)(c).
Summary Annual Report (SAR)
The SAR is a summary of IRS Form 5500 that must be distributed to all plan participants. Within seven months after the close of each fiscal year of the plan, the sponsor must issue a summary annual report on one of the Department of Labor 5500 forms.
These forms provide information about plan activity and assets. ESOP participants must be able to inspect and copy the report. ESOP participants also receive a shorter version of the form.
Summary Plan Description (SPD)
An SDP is a required, comprehensive, easily understood document all ESOP sponsors must provide to all employees. An SDP explains the rules of the ESOP, procedures for questioning or lodging complaints over ESOP operations, and names and addresses of the sponsor and fiduciaries.
All ESOP participants must receive the document within 90 days of becoming a participant, and the SPD must be updated when material plan amendments are made, or, if there are none, every five years.
The process of determining the value of the company.
Since an ESOP is a qualified defined contribution plan, it needs to follow the vesting rules described in IRC Section 411(a)(2)(B). These rules say a plan must use a schedule at least as beneficial as the three-year cliff vesting schedule or the six-year graded vesting schedule for employer discretionary contributions.
A participant's vested account balance is their account value multiplied by their vested percent.
Voluntary Correction Program (VCP)
If your retirement plan isn’t currently being audited by the IRS, and you have mistakes with either the language in the plan document or how you’ve run your plan, you can apply to correct the mistakes under the Voluntary Correction Program (VCP).
Waiver of Participation
Employees may waive participation in an ESOP by certifying that ESOP provisions have been fully explained and that they voluntarily and knowingly choose not to participate in the ESOP. Participation waivers may be revoked. Terms of waivers must be clearly communicated on waiver forms.
Still Have Questions About ESOP Terminology & Definitions?
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